If you had access to an incredibly powerful tool that could change your financial future – would you not want to use it? Of course you would!

Thankfully, we all have access to Compound Interest. 

Compound interest happens when the final total of a collection of money is significantly higher than the amount of money put in over a period of time. 

What does that mean? 

Essentially, the amount of money that I put into an account and the amount of money that I have at the end are different numbers, with the amount at the end being a lot higher than what I put in. 

That’s a great thing! But, how does compound interest grow my money?

Three Ingredients of Compound Interest

There are three different components in determining how your money grows: amount invested, the rate of return on your investment, and length of time invested.

Amount invested

The first thing to consider is how much money do I have to grow?

If I were to invest $100, my grow rate would be off of $100.  Instead, if I were to invest $1,000 dollars, my grow rate would then be off a higher amount and making all other factors the same, I would have a higher amount of growth.

Rate of Return

The rate of return is the percentage your money has either risen or lowered in a specific period of time.

If I invested $1,000 and at the end of the year my investment turned into $1,100 then my rate of return was 10%.

Assuming I have a higher rate of return, then my year end dollar amount would be higher.

On the other hand, if I have a lower rate of return then 10%, then my year end dollar amount would still be higher than the initial $1,000, but not as high as if my rate of return was 10%.

Length of time Invested

This is the key component to compound interest. The longer I allow the rate of return to work on my invested amount, the more benefit I have.

This is because as my initial amount grows from the rate of return each year, I have larger amounts to grow each consecutive year. The longer I allow that to happen the more benefit I find.

Below is a chart to help illustrate this.

As you can see, at the end of year 5, the numbers have grown a lot from the initial investment. The important part though right now to understand is not the jump from year 1 to year 5, but the jump from year to year.

From year 1 to year 2 I gained 100 dollars because I gained 10% of my initial investment. From year 2 to year 3 I also gained 10% of my investment but my investment was not $1,000 anymore. Now it is $1,100. So keeping the same return of 10%, I now gained $110 rather than only $100.

Jumping down and looking at year 4 to year 5 I gained $146 because my new base number in year 4 was $1,464 not the $1000 I had in year 1 and my return rate of 10% is off of $1,464 not $1,000 anymore.

Now this is a small sample of only 5 years. Let’s look at another chart to see a larger length of time using the same amounts.

My one time, $1,000 dollar investment turned into $28,406 dollars. Is that not incredible?

An important point here is that this chart is working off of a one-time investment of $1,000. I did not invest more each year for this example.

I could have though and these numbers would be much higher because remember, the growth is dependent on the amount invested, rate of return and length of time.

If I add more, changing the amount invested I will have a better number at the end.

Likewise, if I get more than 10% for my rate of return, I will also have a higher number at the end and if I let the money sit for longer than 35 years, I would have a larger amount at the end.

Just for fun, here is a final chart to illustrate the power of compound investing when it is really given money, a good rate, and a long time to work.

Let’s assume I make a reasonable amount of money and I want to invest $5000 dollars at age 25. Each year I can continue to put in an additional $5000 dollars at a rate of 10% for 35 years. Let’s see how much I would have at the age of 60.

Over those 35 years, putting in $5,000 at the beginning of each year, I put in a grand total of $180,000.

Because of the high interest rate of 10% and the length of time I had to let it work, compound interest made me an additional $1,464,787.

That is 8 times the amount of money I put in!

Looking at this last chart, you can see why compound interest is such a powerful and incredible tool!  The growth it provides is astounding.

Are you taking advantage of it? If not, what is holding you back?

Want more motivation? Did you know compound interest can apply to any and all retirement accounts. 

Hopefully, now you understand compound interest a bit more and can start letting your money work for you.